There is panic in the markets: reviving memories of the peak of the financial
crisis, investors have recently appeared less concerned about the return on their
money, rather focusing on the return of their money. In what is a hallmark
of grave investor concern, investors are paying for the privilege of lending
money to the U.S. government: the yield on one and three month Treasury bills
has been flirting again with negative yields. What's the panic about? In our
analysis, it's the market's urgent call to address one of the key flaws in
our financial system: cost-based accounting by financial institutions, notably
as it pertains to money market funds. To make the U.S. dollar safer, as an
important step, the present form of money market funds must to be abolished
- let us explain.

Money market funds currently hold about $2.7 trillion dollars in assets; investors
deposit money in such funds to park cash and earn a return. However, whereas
a bank deposit carries counterparty risk to the financial institution, money
market funds are legally self-standing entities with credit risk to the underlying
securities. Just like other investors, money market fund managers have been
chasing yields to generate returns, or simply to cover their costs. Chasing
yields is, by definition, not risk-free; yet investors in money market funds
generally believe their money is safe. While many appear to take comfort in
the fact that the industry may be too big to fail, investors have recently
started voting with their feet, signaling that the paltry returns in money
market funds are not worth the risks. Indeed, investors appear to prefer buying
Treasury Bills at negative yields rather than parking their money in money
market funds.

As a money market fund manager, where do you invest when only paltry, or negative
yields are available? How about European banks? What? Don't U.S. money market
funds only invest in U.S. dollar-denominated securities? As we pointed out
in a recent
analysis, many taxable non-government money market funds ($1.6trn of the
total money market assets) are heavily invested in U.S. dollar denominated
commercial paper issued by European banks. How does almost 5% of total assets
invested in commercial paper issued by BNP Paribas, the French bank with billions
in exposure to Greek government debt, sound? In fact, our analysis found that
50% of total money market fund exposure to European financial institutions
appears to be common; we have seen over 70% exposure. If you believe these
institutions are too big to fail, you might not need to worry; but why engage
in the risk that you are wrong when the reward (yield) is so small? That's
exactly the question institutional investors have been asking recently.

Money market funds try to keep a stable net asset value by employing what
is called amortized cost accounting: the market value is ignored, assuming
the issuer of the debt will pay in full. The justification for this practice
is that money market funds invest in highly rated securities of extremely short
duration. That may be correct, but in case of a systemic shock and a flight
from money market funds, there is a risk that money market funds would need
to liquidate holdings at a loss; additionally, an outright default cannot be
ruled out in light of the Lehman Brothers experience.

On a recent trading day, when Portugal's debt was downgraded to junk status,
the yield on three month U.S. Treasury Bills dipped into negative territory,
as institutional investors became concerned about the contagion risks associated
with European bank exposures to Portugal. On July 7th three-month Treasury
yields came back into slightly positive territory after the European Central
Bank (ECB) declared it would continue honoring Portuguese debt in ECB refinancing
operations, mitigating the contagion risk. Indeed, "Too-Big-To-Fail" was at
work once again: ECB President Trichet effectively came running to the rescue
of U.S. investors' money market funds. This situation is untenable; our policy
makers are drowning the industry in bureaucracy, but ignoring the obvious to
make our financial system more stable: work with market forces, move to market-based
accounting ... and abolish money market funds in their present form.

If money market funds were to use market based accounting, any shock could
be anticipated and reflected in the market price of such funds. When a problem
is discovered early, it may cause pain and losses, but wouldn't lead to a systemic
meltdown. Too many still believe we can get through the financial crisis without
anyone taking any losses; but make no mistake about it: errors have been made
and someone must pay for it.

However, there is a major impediment to move towards market-based accounting:
It would require money market funds to abolish stable net asset values; Kansas
Fed President Tom Hoenig has been a leading advocate to force money market
funds to do just that (see "Restructuring
the Banking System to Improve Safety and Soundness"). However, that may
not be possible because the underlying securities held by money market funds
are not easily priced as there may not be a market for them. To understand
why, note how commercial paper is created: unlike Treasury Bills that are extremely
liquid, commercial paper is often not traded at all. Someone interested in
buying, say, US$50 million in commercial paper from institution ABC is likely
to approach a broker, who in turn will call institution ABC, negotiating terms
(amount, duration, yield) that are acceptable to both lender and creditor.
Such negotiation can take as little as a minute or two, with commercial paper
issued the same or next day. To make it worth the effort of the parties involved,
there may be a minimum order size of $10 million or often substantially higher.
The yield is negotiated by lender and issuer, although typically rather obvious
given market conditions in the context of the creditworthiness of the issuer.
Selling commercial paper back into the market is possible, but depends on the
availability of a willing buyer; generally speaking, there is not an active
market, as the lender typically intends to hold the paper to maturity. As a
result, while one can infer a price based on an assessment of the riskiness
of the issuer and other observable market conditions, commercial paper does
not lend itself well to market based valuations.

While tax-exempt money market funds don't carry commercial paper, some municipalities
have their interest payments tied to the fate of European banks (c.f. WSJ:
Euro Jitters Ricochet Across U.S.). Even without European exposure, municipalities
certainly are not risk-free, either. And even Treasury Bills fluctuate in value.
Money market funds that rely exclusively on the resources of its own holdings
should not have a stable net asset value; the present pricing structure of
money market funds is inherently flawed - in their present form, money market
funds should be abolished.

What would be the alternatives? What are the implications for the markets,
in the U.S. and beyond?

For investors that prefer to have counter-party exposure to the underlying
securities rather than a bank where the cash is held (a very valid concern
during 2008 in particular), the appropriate instrument to hold commercial paper
may be an actively managed exchange traded fund (institutional investors may,
of course, obtain the commercial paper directly as well). In an exchange traded
fund, buyers and sellers determine the value of the underlying securities.
As exchange traded funds have to report their holdings on a daily basis, a
rational investor is free to decide whether to offer a premium or discount
to the amortized cost accounting employed at the fund level. Such funds won't
have a stable net asset value. The downside of such funds is that there is
a bid/ask spread, as well as a brokerage commission due in buying and selling
such funds. The cost of buying and selling such funds should be very low, and
the risks associated with the underlying issuers held within a fund, along
with present market conditions, would be more accurately reflected in the market-derived
price of such a fund.

Another alternative is to have the industry shift towards a banking model.
Interest bearing deposit accounts come in many flavors. Given the consolidation
already under way in the industry, it could be possible for the few large players
to move towards such a model. The most obvious would be a deposit account that
has a clear mandate to invest in commercial paper and other high-quality, short-term
debt securities. The key difference to money market funds would be that investors
have counter-party exposure to the bank. There is no fluctuating net asset
value to worry about, because any losses suffered by the investment would be
covered by the resources of the bank. This model would continue to allow a
thriving commercial paper market while addressing the key shortcoming of money
market funds: a stable net asset value with inadequate backing in case of losses.
In practice, it is assumed that the sponsor or a money market fund would step
in when there are losses; but implicit guarantees are a very bad way of running
a market, a business or regulatory policy. Those that don't like the thought
of taking on the counter-party risk of a bank should seek out alternatives.

Federal Reserve (Fed) Chairman Bernanke has also become more vocal about the
challenges of the "shadow banking system." What is needed, though, is action,
not words. This multi-trillion dollar misallocation of capital causes financial
instability. Current Fed policies are literally financing foreign financial
institutions, not only attracting political scrutiny of Fed policy, but also
distorting the funding cost of foreign institutions. We don't have any problem
with U.S. investors buying U.S. dollar denominated commercial paper issued
by European banks. But buyers of such paper must be risk-friendly investors.

As U.S. money market funds grow more cautious about U.S. dollar denominated
commercial paper issued by European banks, we have seen headlines about increased
funding cost of, for example, a leading Spanish bank. Ultimately, liquidity
in intra-European markets should increase if U.S. money market funds don't
act as a vacuum cleaner to suck up all liquidity. It may, though, imply a higher
borrowing cost for European issuers. Important is not that the cost of funding
is low, but that it is based on fair market conditions. Economist Murray Rothbard
has quoted former German Reichsbank President Schacht as saying, "Don't give
me a low [interest] rate. Give me a true rate. Give me a true rate, and then
I shall know how to keep my house in order."

We have argued since 2006 that there may be no such thing anymore as a safe
asset and investors may want to take a diversified approach to something as
mundane as cash. In our work, we also include the currency risk of the U.S.
dollar; in our next analysis, we shall discuss "return on your money" rather
than a "return of your money", suggesting policies that would strengthen
the U.S. dollar. Please join
us for a Webinar on Thursday, July 21 and sign
up to our newsletter to be in the loop as this discussion evolves. We manage
the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the
Merk Hard Currency Fund; transparent no-load currency mutual funds that do
not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard
money, macro trends and international investing. He is considered an authority
on currencies.

The Merk Absolute Return Currency Fund seeks to generate positive absolute
returns by investing in currencies. The Fund is a pure-play on currencies,
aiming to profit regardless of the direction of the U.S. dollar or traditional
asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies
versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies
that may include, but are not limited to, the currencies of China, Hong Kong,
Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea,
Taiwan and Thailand.

The Funds may be appropriate for you if you are pursuing a long-term goal
with a currency component to your portfolio; are willing to tolerate the risks
associated with investments in foreign currencies; or are looking for a way
to potentially mitigate downside risk in or profit from a secular bear market.
For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges
and expenses of the Merk Funds carefully before investing. This and other
information is in the prospectus, a copy of which may be obtained by visiting
the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please
read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in
currency exchange rates will affect the value of what the Funds own and the
price of the Funds' shares. Investing in foreign instruments bears a greater
risk than investing in domestic instruments for reasons such as volatility
of currency exchange rates and, in some cases, limited geographic focus,
political and economic instability, and relatively illiquid markets. The
Funds are subject to interest rate risk which is the risk that debt securities
in the Funds' portfolio will decline in value because of increases in market
interest rates. The Funds may also invest in derivative securities which
can be volatile and involve various types and degrees of risk. As a non-diversified
fund, the Merk Hard Currency Fund will be subject to more investment risk
and potential for volatility than a diversified fund because its portfolio
may, at times, focus on a limited number of issuers. For a more complete
discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk
Investments LLC, and reflects the current opinion of the authors. It
is based upon sources and data believed to be accurate and reliable. Merk
Investments LLC makes no representation regarding the advisability of investing
in the products herein. Opinions and forward-looking statements expressed
are subject to change without notice. This information does not constitute
investment advice and is not intended as an endorsement of any specific investment.
The information contained herein is general in nature and is provided solely
for educational and informational purposes. The information provided does
not constitute legal, financial or tax advice. You should obtain advice specific
to your circumstances from your own legal, financial and tax advisors. As
with any investment, past performance is no guarantee of future performance.